Japan Tobacco Inc. (OTCPK:JAPAF) Q3 2020 Earnings Conference Call October 30, 2020 4:00 AM ET
Naohiro Minami – Chief Financial Officer
Conference Call Participants
Good evening, and thank you for joining today’s call. I’m Naohiro Minami, Chief Financial Officer of the JT Group. I will take you through the Third Quarter Earnings Results.
I will start with our consolidated financial results for the first nine months of 2020. Please look at Slide 4. As a note, the nine-month results and advised full year forecast for 2020, which I will explain today, include effects of the application of hyperinflationary accounting in Iran and Sudan.
Revenue fell by 2.5% year-on-year to JPY1,592 billion, reflecting decreases in the Japanese domestic tobacco, pharmaceutical and processed food businesses despite growth in international tobacco business.
In the international tobacco business, revenue increased on a reported basis. The negative impact of the pandemic is expected to be about JPY45 billion over these nine months. Next, adjusted operating profit at constant currency grew by 6.3% year-on-year. While the tobacco and processed food businesses continue to see COVID-19 disruptions, increases in the international tobacco and pharmaceutical business drove AOP growth at constant currency. On the other hand, currency headwinds expanded. Consequently, adjusted operating profit on a reported basis decreased 2.2% year-on-year despite solid currency-neutral performance. Operating profit and profit attributable to the owners of the parent company declined for the reasons outlined on the slide.
Let me now review performance highlights for each business. Please turn to Slide 5 for volume performance in the Japanese domestic tobacco business. Overall, the tobacco industry was down over 1% year-to-date as the effects of the pandemic, revised regulations in April 2020, price revisions in October 2019, and natural decline were partially offset by transitory surge in demand ahead of the October 2020 price revision.
In the previous quarter, when I explained how the pandemic-related disruptions have affected the Japanese domestic tobacco business, I mentioned two main impacts, the first being a significant transient drop in the RMC industry volume due to temporary closure of designated public smoking areas, the other being the lasting effects of smoking cessation reduction.
Our analysis indicates that the effects of cessation and reduction continue. However, the magnitude of the impact in the third quarter was less than that in the second quarter when both these impacts were prevalent.
The performance of RMC industry volume and RRP industry size are shown in the slide. While the RRP category size continues to expand, partly due to the effects of COVID-19, RMC industry volume continues to decline. Having said this, the overall trend for the tobacco industry in both RMC and RRP combined has been more resilient than anticipated.
Looking at our volume performance, RMC shipment volume was down 5.9%. We attribute this to a lower nine-month share year-on-year, led by intense competition in the value segment as well as a drop in RMC industry volume. However, the July-September quarterly share was up year-on-year.
RRP sales volume was up year-on-year, in line with our initial business plan. Ploom S 2.0 introduced in July has shown a solid start. As a result, the RRP category share on a sell-out basis reached to a level of about 11% this quarter. Our analysis shows that RRP category growth also contributed to our RRP volume increase.
As shown in the reference note at the bottom right, I would like to briefly cover the transitory demand increase that occurred ahead of the October 2020 price revision. We estimate the demand increase to an equivalent of a 0.4 month volume and expect that the impact of this demand will be neutralized by the year-end.
Although we do not anticipate any major surprises in consumer trend after the price revision, we believe it is too early to draw any conclusions in terms of its impact as the demand is yet to return to normal.
Slide 6 shows the financial results for the Japanese domestic tobacco business. Lower volume and negative price variances affected the top line for RMC. However, the transitory demand increase alleviated the impact of the decline in volume in the third quarter compared to the first and second quarter.
RRP-related revenue also declined year-on-year, mainly due to lower sales of devices and accessories as well as the tax hike absorption in selected brands in October 2019, when the tax regime for RRP was revised.
COVID-19 negatively impacted the top line by around JPY20 billion in over these nine months. We attribute over half of this impact to the Japan duty-free and China businesses.
Now I’d like to talk about the impact of the domestic market besides duty free. As I mentioned in the previous slide, the trend of smoking cessation and reduction continued to negatively affect consumer demand from July to September. However, its magnitude was relatively limited compared to the last quarter.
Resulting core revenue is as shown in the slide. Adjusted operating profit was down 16% year-on-year to JPY139 billion due to a decrease in the top line and increase in investments, notably in RRP. These impacts are partially neutralized by significant cost savings due to lower indirect expenses as well as efficient cost management and investments on high-priority activities.
Please turn to Slide 7, where I will cover our performance in the international tobacco business. Our volume performance in the international tobacco business was resilient with a decline of only 2.6%. We saw solid share momentum in markets including Europe, mainly for GFB, and volume temporarily remained on the upside in markets with higher unit prices like in the UK, France and Taiwan. These factors essentially due to lower cross-border travels related to COVID-19.
The solid volume performance alleviated the impact of lower volume in Russia and Bangladesh as well as the Duty-Free business and emerging markets affected by the pandemic. Let me briefly comment on Russia. As I mentioned in the previous quarter, industry volumes continued to decline at a high rate for the reasons shown on the slide. We are carrying out portfolio adjustments to enhance our price competitiveness as a response to the share decline.
Regarding Ploom Model S, which we introduced in Moscow in March, we are expanding the launches in new cities through additional key accounts. We will continue to respond with agility to enhance our RFP presence in Russia. As mentioned in the final bullet, Russian government passed and enacted the bill to expand the tax increase, and we will closely monitor how this larger excise tax hike will play out in our future business.
Moving to the next slide, covering financial results for the international tobacco business. Top line performance was solid over these nine months, driven by pricing gains from the markets shown on the slide as well as continuing temporary volume expansion in markets with higher unit prices, notably Europe, as I explained in the previous slide.
Consequently, as depicted on the slide, core revenue grew both on a currency-neutral basis and on a reported yen basis. We estimate the COVID impact on core revenue over these nine months as unfavorable by about JPY17 billion.
While I reported in my second quarter announcement that the impact in the first half was around JPY20 billion, the impact reduced year-to-date. This can be attributed to volume growth in markets with higher unit prices due to higher domestic consumption under pandemic conditions.
Adjusted operating profit grew on both a constant currency basis and a reported yen basis, driven by robust top line performance. Despite lower costs under COVID-19 restrictions, net cost increased due to the establishment of our global business service centers and enhanced RRP investments.
As mentioned at the beginning of the presentation, in accordance with the requirements stipulated in IAS 29, we have applied hyperinflationary accounting in Iran and Sudan. The financial results in the table and graph on this slide include adjustments for hyperinflationary accounting as up to where they are presented on a constant currency basis. For further details, please refer to the third quarter earnings report.
Moving on, I will explain our performance in the pharmaceutical business. Revenue decreased mainly due to lower overseas royalty income. On the other hand, adjusted operating profit grew by JPY4.8 billion year-on-year to JPY12.6 billion. This increase was a result of lower R&D expenses marked by the successful clinical trial completions as well as profit growth for Torii Pharmaceutical.
With regard to progress of clinical development in the third quarter, JT received manufacturing and marketing approval in Japan for ENAROY tablets 2 milligrams and 4 milligrams, a new drug specific for treatment of anemia associated with chronic kidney disease as announced in September. This will be listed on the Japanese National Health Insurance Drug Price List in November.
Under pandemic conditions, processed food business continues to see impact from lower demand for foodservice products in the frozen and ambient food as well as the seasonings businesses. We have also seen lower demand in our own bakery business. These impacts exceeded the positive effects observed in household commodities in the frozen and ambient food business. Consequently, revenue and adjusted operating profit were down by JPY6.2 billion and JPY2 billion, respectively.
Regarding the trend after the state of emergency had been listed, impacts from COVID-19 have improved, but situations have not fully restored. Over these nine months, COVID impacted the top line negatively by about JPY7 billion.
Now I will talk about the revised forecast for 2020 from the next slide. Slide 11 explains the revised consolidated forecast announced today. In an ongoing COVID-impacted environment, we have revised our revenue upwards by JPY60 billion based on better top line performance in the international tobacco business, as well as an increase in overseas royalty income in the pharmaceutical business.
Adjusted operating profit both at currency-neutral and on a reported basis are revised upward, driven by the upward revision in the Japanese domestic and international tobacco businesses as well as the pharmaceutical business.
While the exchange rate assumptions have been revised unfavorably, the scale of the impact is limited. Operating profit and profit attributable to the owners of the parent company have been revised upwards by JPY42 billion and JPY24 billion, respectively, as a result of the upward revision of adjusted operating profit as well as the upside of proceeds from the sales of real estate.
We have concluded the sales contract for the former JT head office, JT Building, and the proceeds of schedule will be recognized in the fourth quarter of this year. Free cash flow has been revised upwards by JPY65 billion, notably driven by upward revision of operating profit and improved working capital.
Ever since we announced our initial forecast in February this year, it goes without saying that the COVID-19 disruptions and its protracted impact, as well as the currency fluctuations, have changed our business environment drastically. However, by minimizing these impacts through efficient cost management and focusing investments on high-priority activities, we now expect that our forecast for adjusted operating profit and profit attributable to the owners of the parent company will exceed our initial outlook.
Next, I would like to explain our forecast by business segment. Please see Slide 12 for details of the Japanese domestic tobacco business. Based on results up to the third quarter, our volume assumptions have been revised as shown on the slide. We expect that the decline rates for total tobacco and RMC industry volume will improve.
This is because considering the tentative date, we have revised our assumptions of the effects derived from regulatory changes in the pandemic and fine-tuned our estimates of the impact from the actual price revision in October 2020. In particular, we now expect to see less impact from the pandemic than we anticipated.
RRP market size guidance remains essentially unchanged, but is expected to be toward the high end of the previous estimate. The outlook for JT RMC shipment volume has been revised downward because we have reconsidered our assumptions, taking into account increased competition and lower price segment among the manufacturers with new product introductions.
Apart from expanding our offerings in the little cigar category, we have also launched 2% products from Mevius line at a lower price point, enhancing our efforts to capture down-trading consumers mainly from Mevius. The RRP shipment volume guidance of over 3.5 billion sticks equivalents remains essentially unchanged. It is expected to be towards the high end of the previous estimate, considering the performance of Ploom S 2.0 and RRP category growth.
As shown in the graph below, Ploom S market share within the category has continued to expand since introduction of Ploom S 2.0 in July. We will continue our efforts to strengthen our presence within the category. Examples include the launch of Ploom TECH+ with, which will be sold in Tokyo and on our online shop from November.
Based on these volume assumptions, we have revised our financial forecast, as shown on Slide 13. Despite the impacts of contraction of Japan duty-free and China businesses due to proactive COVID disruptions as well as the downward revision of the RMC volume outlook, these impacts were neutralized by factors including the RRP volume increase. As a result, core revenue remains unchanged.
However, the cost savings exceeded these negative impacts. Most notable within the cost savings are factors such as lower indirect costs under the pandemic conditions as well as effective cost execution in order of priority. As a result, we have revised adjusted operating profit upward by JPY6 billion to JPY166 billion, an 11.3% decline year-on-year.
Next, I will explain the revised forecast for the international tobacco business. Please turn to Slide 14. First, let me focus on the volume outlook. Total and GFB shipment volume had a revised to about a 4% decrease and about a 1% increase, respectively. These upward revisions are driven by stronger volume performance, particularly in Europe. This performance was supported by reflecting higher domestic assumption mainly in the UK and Taiwan as well as continuing share momentum by capturing down-trading consumers in markets like the UK.
In the third quarter, the pandemic impact has been limited relative to our previous assumptions, which also contributed to this upward revision. Though with that said, this revision was partly offset by lower volumes, mainly in emerging markets like Bangladesh as well as the contraction of duty-free business with fewer people traveling.
Turning to the financial forecast. We have revised core revenue on both a constant currency and reported yen basis upward by US$500 million and JPY60 billion yet, respectively, mainly due to the positive volume assumption mentioned earlier.
With the top line revision, we have also revised the adjusted operating profit on both a currency-neutral and reported yen basis upwards by US$170 million and JPY15 billion, respectively. Even excluding contributions from hyperinflationary markets, we estimate that adjusted operating profit on a currency-neutral basis will grow by double digits. Forecasts on a reported basis are revised upwards, as we expect that the robust currency-neutral performance will see continuing unfavorable currency headwinds.
With the next slide, I would like to explain the revised forecast for the pharmaceutical business. As you can see on the slide, our forecast for revenue and adjusted operating profit has been revised upward by JPY2 billion and JPY3 billion, respectively. Expansion of overseas royalty income led to core revenue to an upward revision, while we revisited adjusted operating profit based on improved top line as well as lower costs attributed by pandemic-related operational restriction.
Turning to the processed food business. The revenue forecast was revised downward by JPY2 billion. This reflects a delay in recovery compared to the outlook in the second quarter, affecting some product categories for the food service industry and the frozen and ambient food business. On the other hand, our forecast for adjusted operating profit remains unchanged, and we remain hopeful of achieving our targets, mainly by taking cost-saving initiatives to alleviate top line contraction.
Finally, please refer to Slide 17. As I have explained today, our forecasts are revised upward following the strong year-to-date performance as well as efficient cost management while we continue to invest in high priority activities, and we have confidence in achieving the revised forecast.
Having said this, to develop future business plans, we must consider the potential risks, like those shown on the slide. We monitor a wide range of factors such as the discussion regarding potential tax increases, weak recovery of the duty-free business, market-specific risks, including Brexit and economic sanctions against Iran, the impact of COVID-19 on consumer affordability and behavior and other risk factors we may discover outside our current scope.
As mentioned on the slide, there are no changes in our capital resource allocation policy and business investment prioritization. Future allocation will be considered in light of profit levels for the next year onwards. From the business investment perspective, in 2021, we will strengthen investments in RRP to prepare for the launch of new heated tobacco products. Furthermore, given the highly uncertain business environment and foreign currency fluctuations, we will closely monitor their impact on our profits.
Thank you for your attention.